Volatility, Uncertainty and...

The most obvious impact will be higher food prices. This past weekend one of the Globe and Mail's front-page stories was "The new global menace: food inflation" (link to story). The story highlighted what is now an increasingly common response - countries from Russia to Argentina to Egypt to Vietnam have imposed export tariffs or export restrictions to keep domestic food prices from rising. These developments not only threaten trade agreements and negotiations, they also signify a new era, one in which agriculture is increasingly linked with global geopolitical events.

For the last 40 years or so, the price of grain [cereals, oilseeds and pulses] has been largely determined by their cost of production. Prices generally followed a downward sloping floor, the slope of which was determined by productivity and yield increases that lowered costs. Prices did not fall much below this floor because farmers would build up stocks rather than sell at below cost. Prices would, however, spike occasionally when stocks weren't sufficient to meet shortfalls in production resulting from droughts, pests or disease damage.

The development of biofuels has fundamentally altered the above relationship. The price floor for cereals and oilseeds will no longer be their cost of production, but rather their next best use, namely fuel production - thus oil prices will effectively determine the price floor. Stock holding behaviour is also likely to be affected - if supply exceeds demand, ethanol production is likely to suck up any excess cereals in North America, resulting in consistently low stock levels. The result will be increased volatility, since stocks will not be present to offset droughts and other production shortfalls. Oil industry shocks from political conflicts and major weather events will also affect grain prices.

The result is likely to be a continuation of what the industry has seen lately - short-term commodity exchange prices moving up or down the limit, and long-term prices being highly uncertain. This volatility and uncertainty will have profound implications for the industry. As prices become increasingly less predictable, planning - whether for farmers or agribusiness firms - will become more and more difficult. Hedging - an often-used mechanism for dealing with future price uncertainty - may become more difficult due to increased basis risk. In the extreme, this lack of predictability may mean that some markets cease to function - this will happen if buyers are so uncertain about the future value of what they are purchasing that they cannot pay sellers enough today to entice them to sell.

What will be the response of governments and the private sector to this situation? Based on what happened historically, it is reasonable to infer that various governments - including those of United States and China - will once again hold stocks. Private sector users - such as large milling firms - may also begin holding stocks. Although such behaviour is likely to reduce uncertainty and volatility from what it otherwise might have been, overall agricultural prices are likely to exhibit greater fluctuations in the future than they have historically.

The link between grain prices and geopolitical events will not only be via the price of oil. As grain prices rise, food prices and food security are likely to emerge as key issues for both importing and exporting countries. These concerns are likely to result in increased protectionism as countries struggle to deal with the political and social problems that higher food prices create (witness the strikes by Argentine farmers in the past weeks). These problems can, in turn, have ramifications for political stability in a number of regions of the world.

After roughly 40-50 years of being relatively independent of global geopolitical events, agriculture may once again be thrust back into their midst. If something has changed and the current situation is not just another blip in the commodity cycle, then dealing with this increased interdependence, and the volatility and uncertainty that it creates, will require participants - be they farmers, agri-business leaders, or policy makers - to re-conceptualize how the industry operates and to re-think the strategies that are now appropriate. Since such work is difficult and will not be easily or immediately accomplished, the worry is that industry players will fail to do it - and the industry will not adjust properly to what would be a new reality.

This blog entry was authored by Murray Fulton. To read additional Illative Blog entries or to leave comments on this entry, please visit www.illativeblog.ca. The Illative Blog is an initiative by the Knowledge Impact in Society (KIS) Project based out of the University of Saskatchewan. Email correspondence can be sent to kis.project@usask.ca